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PART I MICROECONOMICS
Lecture 1
Economics Definition and Nature & Scope of Economics Divisions of
Economics

ECONOMICS ITS SUBJECT MATTER

Why Economics comes?

Economics is the science that deals with production, exchange and consumption of
various commodities in economic systems. It shows how scarce resources can be used to
increase wealth and human welfare.
Nature gives abundant natural wealth to live. But the availability of each resource is
limited. Human being has to satisfy the biological, physical and social needs. In order to
fulfill the needs they involve economic activity. The central focus of economics is on
scarcity of resources and choices among their alternative uses. This scarcity induces people
to make choices among alternatives and the knowledge of economics is used to compare
the alternatives for choosing the best among them. For example, a farmer can grow paddy,
sugarcane, banana, cotton etc., in his garden land. But he has to choose a crop depending
upon the availability of irrigation water.
Two major factors are responsible for the emergence of economic problems. They are:
i) the existence of unlimited human wants and ii) the scarcity of available resources. The
numerous human wants are to be satisfied through the scarce resources available in nature
creates the economic activity. Economics deals with how the numerous human wants are
to be satisfied with limited resources. Thus, the science of economics centres on want effort - satisfaction.
WANT
SATISFACTION
EFFORT
Economics is a science which studies human activities and explains how a man
utilizes his limited resources for the satisfaction of his unlimited wants. To satisfy these
wants one has to earn resources. So, every one of us is undertaking some activity. We are
all engaged in what is called economic activity. Thus wants-efforts-satisfaction sums up the
subject matter of economics.
Economics not only covers the decision making behaviour of individuals but also
the macro variables of economies like national income, public finance, international trade
and so on.
A. DEFINITIONS OF ECONOMICS
Several economists have defined economics taking different aspects into account. The
word Economics was derived from two Greek words, oikos (a house) and nemein (to
manage) which would mean managing a household using the limited funds available, in
the most satisfactory manner possible.
i) Wealth Definition (WD)

Adam Smith (1723 - 1790), in his book An Inquiry into Nature and Causes of Wealth
of Nations (1776) defined economics as the science of wealth. i.e. economics enquires
into the factors that determines the wealth of the country and its growth. He
considered that the individual in the society wants to promote only his own gain and in
this, he is led by an invisible hand to promote the interests of the society though he has
no real intention to promote the societys interests.
Other wealth definitions are;
J.E. Cairns: In his book The character and logical method of political Economy said
that economics deals with the phenomenon of wealth.
J.S. Mill: The practical science of the production and distribution of wealth (dictionary)
J.B. Say: Economics is the science which treats of wealth.
Criticism:
1. Too much importance given to wealth, not considered the human welfare.
2. Ruskin and Carlyle condemned economics as a dismal science, as it taught
selfishness which was against ethics.
3. Marshall and Pigou considered the common divergence of private and social
interest.
Hence, wealth definition was rejected and the emphasis was shifted from wealth to
welfare.
ii) Welfare Definition (Material definition -MD)
Alfred Marshall (1842 - 1924) wrote a book Principles of Economics (1890) in
which he defined Political Economy or Economics is a study of mankind in the
ordinary business of life; it examines that part of individual and social action which is
most closely connected with the attainment and with the use of the material requisites
of well being.
Superior aspects of Material Definition (MD) over Wealth Definition (WD):
1) In WD the scope is limited as it studies only the nature and causes of wealth of
nations but in MD the scope is widened as it includes the study of mankind also as an
important aspect of economic studies.
2) In WD wealth is considered as an end in itself but in MD wealth is not the end but
only a means to an end, the end being human welfare.
3) In MD human activities are divided into economic and non -economic and so the
scope is widened to both aspects.
Critical evaluation
By Lionel Robbins in his book An Essay on the Nature and Significance of Economic
Science (1932) criticized the material definition as follow;
1) MD includes only material things and ignores non-material things such as service of
doctor etc.
2) According to MD Economics includes study of all materials that provides only welfare
to the people but some of the materials such as opium tobacco, ganja, etc. are harmful to
the people. Yet they have been studied under economics. So it contradicts with human

welfare. Similarly wars do not contribute to material welfare but it has its own impact
on national economy. Thus it contradicts with material welfare.
3) According to MD Economics is classificatory rather than being to be analytical such as
economic and non economic, productive and unproductive.
4) According to Marshall, Economics is a social science and studies his behaviour in his
ordinary business of life as a member of society. But it doesnt study about a saint in
Himalaya. But According to Robbins he should be also included as he has scarce
resource such as time etc.
3. Science of Scarcity
This Scarcity Definition (SD) was given by Robbins. According to him
Economics is the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.
1) Ends: refer to wants. Wants are unlimited and non satiable. So, man has to make choice
between more and less urgent wants. All wants are not equally important some wants
are more urgent and some wants are less urgent.
2) Scarce means: Supply of resources is limited.
3) Alternative uses of scarce means. The scarce means can be put for numerous uses
4) Economics studies human behaviour i.e., Choice making behaviour
5) It is a positive science (Opportunity cost, scale of preference are implied from this
Definition) Supported by Wicksteed, Stigler and Cassel )
Critical Evaluation:
By Frazer, Woolen and Beveridge.
1) SD is considered as only positive science, and normative aspect is ignored.
2) SD does not fully reflect the two of the major concerns of modern economics viz.
growth and stability. (Economic development and stability).
3) SD does not cover the problem of unemployment.
4) SD is essentially a micro analysis (i.e., mere resource allocation) and fails to emphasize
the macro economic character.
5) SD considered economics as a human science instead of social science. SD is
impersonal, colourless and impartial, neutral with regard to ends. The greatest defect is
it is static in content.
4. Modern Growth Definition (GD) by Samuelson (1964)
Economics is the study of how men and society choose, with or without the
use of money to employ scarce productive resources which could have alternative
uses, to produce various commodities over time, and distribute them for consumption
now and in the future among various people and groups of society.
Superiority over Robbins Definition:
1) It explains dynamic changes, i.e., Dynamic in context.
2) It is applicable to barter economy as well as to capitalist, mixed, socialist and communist
economies also.

3) It is also applicable to solve the problems of income, output and employment.

Common Definition:
Economics is a social science concerned with the proper use and allocation of
resources for the achievement and maintenance of growth with stability and with
determinants of income and employment.
NATURE AND SCOPE OF ECONOMICS
In order to discuss the nature and scope of economics, we have to indicate a)
Whether it is a science or an art, b) A positive science or normative science, c) Whether it
can solve practical problems, d) Whether it is a social science and e) the subject matter of
economics.
A. ECONOMICS AS A SCIENCE
For
1) Science has been defined as a systematized body of knowledge, which traces the
relationship between cause and effect. The facts should be systematically collected,
classified and analysed.
2) The phenomena should be easily amenable to measurement. Both the conditions are met
by Economics. The facts for economic analysis are systematically collected, classified
and analysed and the measuring rod used in economics is money.
Against
1) Economists do not agree among themselves. According to Barbara Wooten wherever 6
economists are gathered there are 7 opinions. Complete agreement among economists is
not essential to give economics the status of a science.
2) Inability to predict the future, accurately. Since, Economics deals with highly complex
and variable forces this point can be also compromised.
ECONOMICS AS AN ART
An art is a system of rules for the attainment of a given end. A science teaches us to
know; an art teaches us to do. In a word Science explains and expounds; Art directs; art
imposes precepts or proposes rules.
A science teaches us to know an art teaches us to do. Economics met this condition
also. So, economics is considered as both a science and art simultaneously. Science is in its
methodology and art in its application.
ECONOMICS - PURE AND APPLIED
Now economics is distinguished as pure and applied science. Pure science furnishes
the tools with which applied science works.
ECONOMICS - POSITIVE AND NORMATIVE
Positive Science: A body of systematized knowledge concerning - What is? It
describes. (Classical economists view). Positive science does not indicate what is good or
what is bad to the society. It will simply provide results of economic analysis of a problem.
For example, 12 per cent of the labour force in India was unemployed last year is a
positive statement.
Normative Science: A body of systematized knowledge concerning What ought to be? It
evaluates Twelve per cent unemployment is too high is normative statement comparing
the fact of 12 per cent unemployment with a standard of what is unreasonable. It also

suggests how it can be rectified. Therefore, economics is a positive as well as normative

science.
ECONOMICS A SOCIAL SCIENCE
The process of satisfying wants is a social process, not an individual process.
Economics has thus to study social behaviour. So it can be considered as a social science.
CAN ECONOMICS SOLVE PRACTICAL PROBLEMS?
With the help of economic theories, and various tools, economics can solve the
practical problems faced by the human being.
APPROACHES IN ECONOMICS / (DIVISIONS OF ECONOMICS)
Economics can be studied under two approaches. They are traditional approach and
modern approach.
a) Traditional approach: In the traditional approach economics is studied under five
major divisions viz. consumption, production, exchange, distribution & public finance.
1) Consumption: Using the wealth to satisfy the unlimited wants (consumer surplus )
2) Production: Creation of utility or producing things, Deals with land, labour, capital and
entrepreneur.
3) Exchange: The process of both buying and selling, Price determination and disposal of
products.
4) Distribution: Sharing the fruits of production among the agents of production, i.e. factor
pricing rent for land, wages for labour, profit for entrepreneur and interest for capital.
5) Public finance: How Government gets and spends money?
b) Modern approach: The study of economics is divided by the modern economists into
two parts namely viz., 1. Micro economics and 2. Macro economics.
Micro economics: The word micro means a millionth part. It studies the behaviour of
individual decision making units such as consumers, resource owners, business firms, etc.
It studies the behaviour of individual decision making units in relation to the fixation of
price and output and their reactions to the changes in the demand and supply conditions.
Hence, it is called as price theory.
Macro economics: Macro economics studies the behaviour of the economic system as a
whole or all the decision making units combine together. It concern with aggregates and
averages of the entire economy such as national income, total employment, aggregate
supply, aggregate demand, aggregate output, total consumption, savings and investment,
general level of prices, etc. It is also called as income theory.
LAWS OF ECONOMICS
Like every other science, economics too, has drawn its own set of generalizations,
which are called as laws of economics.
Economic laws or statement of economic tendencies can be measured by money price.
Unlike the laws of natural sciences, the nature of economic law is not indicated by the
word must as in the case of statute law or by ought as in the case of moral law; But
their nature is indicated by the phrase, other things being equal, (ceteris paribus).
METHODS OF ECONOMICS
Economics has methods for the discovery of laws and theories. It uses both Deductive
and Inductive methods.

Deductive Method
The early English economists, classical school tried to build up the science of
economics from a few simple generalizations. The method is called the Deductive,
Analytical, Abstract or A Priori method.
Thus this method descends from general to particular. Starts from certain principles
and carry them down as a process of pure reasoning to the consequences which they
implicitly contain.(General to particular). Eg. General- traders get profit and this can be
verified in case of individual traders.
Inductive method
In this method the facts are examined first and based on that general principle are laid
down. Thus this method ascends from specific to general (Particular to general).
ECONOMIC THEORY
Economic theory is divided into two parts viz. Economic statics and Economic
dynamics. The former is concerned with economic phenomena alone without time element
while the latter give due consideration to the time element.
Economic statics refers to that type of analysis where we establish the functional relation
between two variables whose values relate to the same point of time or the same period of
time. Thus economic statics is the study of static relationship between relevant variables. It
deals with the condition at an equilibrium point.
Economic dynamics is a method which takes into account all the changes, lags, sequences,
cumulative magnitudes, and even expectations. Thus economic dynamics deals with an
evolutionary process in a dynamic manner. There is no assumption of ceteris paribus as in
statics. Therefore dynamics is the study of movements and changes in economic systems. It
analysis the process through which new equilibrium is achieved.
Comparative statics: The method of statics that studies a changing process is comparative
statistics. Comparative statics is a comparative analysis of two static equilibrium positions.
It deals with the conditions at equilibrium, not the process of equilibrium. It studies the
evolutionary process in a series of equilibria and often compare the new position of
equilibrium with that of old ignoring the time element.
But studying the evolutionary process as a whole and at one time is the task of
dynamics.
BRANCHES OF ECONOMICS
There are three branches of economics. They are a) Descriptive economics b)
Economic theory and c) Applied economics. Descriptive economics describes the relevant
facts about an economic field, such as Indian sericulture, agriculture, industry, etc.
Economic theory explains the functioning of an economic system for example; it tells us
how prices of products are determined. In applied economics, we use economic analysis to
explain the causes and significance of economic events.

Lecture -2
Economic systems Definitions and characteristics - capital economy socialist economy
Mixed economy.

2. ECONOMIC SYSTEMS
A set of institutions to solve the economic problems in an efficient way is called
economic system.
Circular Flow of Goods and Money in an Economic System
In an economic system, the two economic units namely households and enterprises are
linked by a circular pattern of economic activities as illustrated in Figure 1.1.The choices
and decisions of these two main units are the deriving forces of economic activity.
Money Payments for Consumer Goods and Services

Consumer
Goods
and
Services-Food,
Clothing etc (Output of Business Sector)

HOUSEHOLDS

BUSINESSES OR ENTERPRISES

1) Consume final goods and

1) Provide goods and services

services produced by
business sector.
2) Provide inputs (labour and

to consumers.
2) Use resources (inputs)
provided by households.

capital) to business firms.

Economic resourcesland, labour and capital (inputs of business sector)
Money Payments for Resources-Rent, Wage and Salaries, Interest and Profit
Figure 2.1: The flow of Goods, Services, Resources and Money Payments in a Simple
Economy
In their households, people make two sets of decisions: a) selling the inputs they own,
primarily their labour and b) buying goods with their incomes. The enterprises or
businesses engage in production, using the labour and other inputs bought from
households. The goods produced by the firms are sold ultimately to the households.
The interactions of households and firms bring together the two sides of economics:
demand and supply. The action occurs in two sets of markets; that for inputs and that for
outputs. In the input markets, households offer their labour, land and capital. Firms buy

these inputs at prices set in the markets. In the output markets, the enterprises sell out the
goods and services to the consumers or households.
ii) Types of Economy: The three types of economic systems are Capitalism, Socialism and
Mixed Economy.
a) Capitalism
Capitalism is a system of economic organization characterized by the private
ownership and use of capital with profit motive.
Table 2.1 Characteristics of Economic Systems
Characteristics

Capitalism

Socialism

Mixed economy

Ownership of
property

Private
entrepreneurs

Mostly by state

Both state and

private

Govt. role

No role

Major role

Medium regulation
and production

Goal

Profit

Welfare

Both profit and

welfare

Capitalisam / free market economy / market system / laissez faire system

Salient features
1. Right of private property
2. Right of inheritance
3. Right of free enterprise
4. Profit motive
5. Competition (both producers and buyers)
6. Price mechanism: The whole system is guided by the price for exchange
7. Basic Economic problems are scarcity and choice and they are solved by price
mechanism (No visible control. Control by price mechanism.)
How the price mechanism works?
1) Demand quantity of goods & services purchased at different prices willingly
2) Supply quantity of goods & services offered for sale at different prices.
3) Equilibrium price price at which demand & supply are equal
This price mechanism solves the problem by the following ways.
What to produce? depends on consumers choice
How to produce? choice of production technology
Whom to produce? based on effective demand by the consumer
Merits
1. The system works automatically, No need for state intervention
2. Flexibility and adaptability is more.
3. Market mechanism fixes the price and there is no unnecessary intervention.
4. Optimum utilization of resources.
5. Induces hard work by providing incentives.
6. Results in higher per capita income, higher rate of capital formation and development.
7. Creates demand for new goods and services and also economise the production by
increasing the scale of production
Demerits
1. The distribution of wealth is inequitable

2. Human welfare is ignored, as there is a chance for moving towards materialism due to
monetary consideration of every economic activity.
3. Waste of resources due to severe competition as all the activities are duplicated (e.g.
Advts., Salesmen) to capture the market share.
4. Leads to Economic instability and unemployment
5. It leads to concentration of economic power with a few persons and emergence of
monopolies.
6. Misallocation of resources. More profit in luxuries than in consumer goods.
7. Chances for class-conflict.
Remarkable Development
Capitalism has transformed into welfare capitalism.
b) Socialism
Socialism is an economic system in which the means of production (capital equipment,
buildings and land) are owned by the state. The main aim of socialism is to run the
economy for social benefit rather than private profit. It emphasizes on work according to
ones ability, and equal opportunities for all regardless of caste, class and inherited
privileges.
Merits of Socialism
1. Avoids wastes of all kinds
2. Leads to economic and trade stability
3. Effective planning leads to optimum utilization of resources
4. Productive efficiency is improved
5. Pressure of social security and welfare
Demerits of Socialism
1. Leads to corruption, inability, nepotism in the administration (red tapism etc.)
2. Rigid and inflexible
3. No freedom for consumers to make decision
4. Concentration of power with the state
5. Failure to bring economic equality
6. Lack of incentives to hard work
Communism is a form of socialism. It was followed in the erstwhile Soviet Union.
Communism means an idealistic system in which all means of production and other forms
of properties are owned by the community as a whole, with all members of the community
sharing in its work and income. People are supposed to work according to their capacities
and get according to their needs. The aim is to create a classless society and the state
machinery is utilized to crush all opposition to achieve this end. The main difference
between communism and socialism is that the former believes and adopts violent
revolutionary methods to capture the machinery of the government while the latter believes
in peaceful and parliamentary methods.
c) Mixed Economy
It is neither pure capitalism nor pure socialism but a mixture of the two. In this system,
we find the characteristics of both capitalism and socialism. Both private enterprises and
public enterprises operate mixed economy. The government intervenes to regulate private
enterprises in several ways. Generally, the basic and heavy industries like industries
producing defense equipments, atomic powers, heavy engineering goods etc. are put in the
public sector. On the other hand, the consumer goods industries, small and cottage
industries, agriculture etc. are assigned to the private sector. Eg. Indian economic system.

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Characteristics
1. Co existence of both private and public enterprises. Basic, and heavy industries, defense,
atomic energy, heavy engineering industries are put in public sector. On the other hand
consumer goods industries, small and cottage industries, agriculture are assigned to
private, Government helps and encourages private sector by providing incentives.
2. Presence of both price mechanism and Government directives.
3. Government regulation and control of private sector by issuing licenses, permits etc.
4. Projects meant for social welfare and can not be implemented by individuals due to high
investment is launched by Government
5. Consumer sovereignty is protected.
6. Exploitation of labour by capitalists is controlled by Government.
7. Attempt is made to reduce economic inequalities.
8. Presence of economic planning to promote economic development
9. Development of infrastructural facilities and setting up of big industrial units by the
Government.
Demerits
1. Inefficient Operations: On private by Government by imposing rules and regulation;
On Government due to lack of initiative and responsibility
2. Instability: Chances are there leading towards capitalist outlook.
3. Economic Fluctuations: Private sector industries may not be controlled effectively and also they depend on
market forces. This results in economic fluctuation and unemployment.
How does a mixed economy solve the basic economic problem?
A mixed economic system works out by a combination of private and public sector
enterprise. Each of the sectors is guided by the state for efficient utilization of resources.
The private enterprise makes their decisions based on markets forces. The public sector
enterprises function on the basis of public welfare.
Questions for Review
1. Fill up the blanks:
a) Lionel Robbins definition of economics is known as ------------------b) Rice is a ------------- good while medical service is a -------------- good.
c) Wealth definition was propounded by ------------.
d) Paul Samuelson gave ----------------- definition of economics.
f) Laissez faire is being followed in --------------- economy.
2. Write short notes:
a) Central problems of an economy.
b) Circular flow of an economy.
c) Scarcity definition of economics.
d) Economics as defined by Prof. Samuelson.
e) Economics is both a science and an art.
3. Differentiate the following:
a) Deductive method and inductive method.
b) Micro economics and macro economics.
c) Positive economics and normative economics.
d) Socialism and Capitalism.
4. Answer the following:
a) What are the defects in Adam Smiths definition of economics?
b) What are the merits and demerits of scarcity definition of economics?
c) Explain the traditional approach to the study of economics.
d) Mixed economy is better than other types of economies-Substantiate.

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LECTURE 3

Theory of Consumer behaviour - Utility- definition and measurement cardinal and

ordinal approaches Law of diminishing marginal utility Graphical derivation of
demand curve

CONSUMER BEHAVIOUR

A sound understanding on the common terms related to consumption is essential

before we get into the detailed study on consumption.
i) Consumption
Consumption is an activity of human beings to satisfy their wants. Production is
mainly based on the object of consumption. Goods and services are produced in order to
satisfy the wants of people by the way of consumption. Consumption may also be defined
as destruction of utilities. In the process of consumption involves the destruction of utilities
contained in the goods but not the matter as a whole.
Thus the destruction of utilities may be instantaneous as in the case of food items
that we consume or gradual as in the case of durable goods like house, furniture, TV, VCR
etc. Mere destruction of utility cannot be considered as consumption. E.g. Rotten fruits, or
destruction of TV by an accident or fire etc. While destruction of a good if it yields utility
to the consumer then we termed it as consumption.
Consumption may be direct or indirect.
Direct consumption: Consumption of food items. Satisfaction derived directly without
any delay.
Indirect consumption: Use of oil. While cooking food oil is not consumed directly but the
utility of oil destroyed while it is used for frying.
ii) Wants
Consumption is the study of wants. Anything we desire is a want. The process of
satisfaction of wants is consumption. To satisfy the wants of human being they involved in
economic activities which produces commodities and service, which creates utilities. The
goods and services can be broadly divided into three categories. They are
1. Necessaries, 2. Comforts and 3. Luxuries.
1. Necessaries: Necessaries are those commodities and services that are essential and these
wants must be satisfied.
a. Necessaries for existence: Commodities that are absolutely essential for our very
existence. E.g. Food. Water, cloths, shelter, etc.,
b. Necessaries for efficiency: goods and service are essential for maintaining the working
capacity at a higher level. eg. Nutritious diet, table and chair to student etc.,.
c. Conventional necessaries: goods, which are although not absolutely necessary, yet many
people use them due to habit or custom e.g. Customs like celebration of functions and
habit of drinking coffee, smoking cigarettes, etc.,
2. Comforts: Comforts are commodities and services, which would be consumed over and
above necessaries in order to lead an easy living. Cushion chair in class room.

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3. Luxuries: Luxuries are goods and services, which do not add to efficiency. It means
wasteful expenditure. Ely defines luxury as excessive personal consumption. It
means anything that satisfy a superfluous want. E.g. silk dress, scent etc.
Luxuries are further classified into harmless luxuries (well finished bungalow,
expensive food), harmful luxuries (injurious to health alcohol, smoking etc) and defense
luxuries (which protect the users during crisis- gold ornaments, jewellary etc.,)
Necessaries, comforts and luxuries are relative terms. They are relative to place, time or
Person and the social setting.
Characteristics of wants
1. Wants are unlimited in number and variety. There is no end to human desire. Even
for the poor the wants are gradually increasing.
2. Particular want is satiable: The quantity of a commodity, which a man can enjoy at a
particular time, is limited by his bodily and mental powers. A want is limited by
capacity means that a fixed quantity of any one object is enough to satisfy. This
characteristic of human being forms the basis of the law of diminishing marginal
utility.
3. Wants are complementary: In order to satisfy a single want fully, we may require
several wants together. For example, betel leaf and areca nut, horse and carriage.
4. Wants are competitive: Different wants exist simultaneously and all of them cannot be
satisfied at once. Wants are unlimited but means of the disposal are very meager.
Preference of choices of wants fulfilled is based on income and expenditure. Wants
compete with each other in the matter of preference and we are compelled to select the
important one. This creates the law of substitution.
5. Wants are alternative: For the satisfaction of a particular want different alternatives are
available Coffee, tea, etc., for drinks. Kerosene, firewood for fuel.
6. Wants are recurrent: Each and every wants are required at number of times. E.g. Food
drinks. The frequency is depending on the durability of a commodity. The recurrences
of wants depend on the standard of life.
7. Unconscious wants: Some wants are dormant. The emergence of these wants occur only
after satisfying the conscious wants. A conscious want causes pain and its satisfaction
removes it. E.g. Gifts, prize money.
iii) Goods and Services
Any tangible commodity that satisfies human want is called a good or visible good or
material good. These goods can be seen or felt, (E.g.) rice, book, etc. Any intangible thing
that satisfies human want is called a service or invisible good or immaterial good. (E.g.)
Services of an engineer or a teacher can be sold, but they cannot be seen or felt.
iv) Free Good and Economic Good
A good or service that has no price is called a free good. The air that we breathe
satisfies us. But we do not pay any price for such goods. So, these goods are free goods and
they are not scarce. Rice is a commodity, which commands a price. Such goods are called
economic goods and these goods are scarce.
v) Consumer Goods and Producer Goods
We use goods like rice, pen etc. to satisfy our wants directly. They are called consumer
goods. On the other hand, we use goods like tractor, thrasher, cultivator, etc. to produce

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various other commodities, i.e., these goods do not satisfy our wants directly. Such goods
are called producer goods or capital goods or investment goods.
vi) Perishable Goods and Durable Goods
Goods that decay or perish quickly are known as perishable goods, (E.g.) fruits,
vegetables, fishes etc. Durable goods are those goods that last for a long period of time,
(E.g.) tractor, thrasher etc.
vii) Wealth and Income
In economics, by wealth we mean only economic goods. The production of goods and
services creates income and wealth. Wealth is an economic good which is an easily
transferable (material) good. Immaterial or non-transferable (services) goods cannot form
wealth. Remuneration paid to the different factors of production is called income. For
example, a person leases out his house for rent. Then, the rent is his income. A labourer
earns wages for the labour he renders in the production process. Thus, wealth is a fund and
income is a flow from the wealth. When we refer to income, we say so much amount for a
specific period of time. On the other hand, wealth is termed as the value of all tangible
assets (land, building, money etc.) at a particular point of time.
viii) Real Income and Money Income
Income can be expressed in terms of either commodity or money. If income is
expressed in terms of commodity, it is known as real income. If the income of an attached
labourer or permanent labourer is 10 bags of paddy per year, then it is his real income. The
standard of living depends on real income only. When income is expressed in terms of
money, then it is called money income. For instance, when we say that the income of a
manager is Rs. 2000 per month, then it is his money income.
ix) Standard of Living
The amount of necessaries, comforts and luxuries with which we are generally
accustomed is said to constitute our standard of living. Kirkpatrick defined standard of
living as the measure or the evaluated amounts of different kinds and qualities of
economic goods involved in meeting the physical and psychic needs and wants of the
different individuals composing the family.
Determinants of Standard of Living
1. Standard of living depends on real income and not on money income of the family.
2. It depends on number of members in the family and also on their wants.
3. It depends on price variations of commodities. Lower the prices, the higher is the
standard of living and vice versa.
x) Utility
Utility may be defined as the power of a commodity or service to satisfy a human
want. The term utility should be differentiated from satisfaction. Utility implies
expected satisfaction whereas satisfaction stands for realized satisfaction. A consumer
thinks of utility when he is contemplating the purchase of a commodity, but he secures
the satisfaction only after having consumed the commodity.
a) Utility and Value: The term utility differs from value of a commodity.
1) Utility is the want-satisfying power of a commodity, while the term value would mean
the power of a commodity to exchange for another commodity.
2) Utility is subjective, whereas the value is an objective term.
3) Both economic and free goods have utility. But only economic goods have value.

14

b) Characteristic Features of Utility

1) Utility is relative: The same commodity may have different degrees or magnitude of
utility for different persons.
2) Utility cannot be equated with usefulness: A commodity may not be useful, yet it may
have utility for a particular person. For example, liquor is considered to be harmful to
health, yet it may have a high degree of utility for an alcoholic. Hence, utility carries no
moral or ethical significance.
3) Utilities are independent: Utility of one commodity does not in way affect that of
another.
c) Kinds of Utility: Utility of a commodity may increase due to several reasons.
1) Form Utility: If the physical form of a commodity is changed, its utility may increase.
For instance, the utility of cotton increases, if it is converted into clothes.
2) Place Utility: If a commodity is transported from one place to another, its utility may
increase. For instance, if rice is transported from Tamil Nadu to Kerala, its utility will
be more.
3) Time utility: If the commodity is stored up for future usage, its utility may increase.
During rainy season, water is stored up in reservoirs and it is used at a later time. This
increases the utility of that stored water.
4) Possession utility: by possession of some commodity utility will be there.
d) Cardinal Utility and Ordinal Utility
Alferd Marshall defined the cardinal utility concept. Utility is measurable and can be
expressed in terms of unit of satisfaction. For example, an apple may yield to a consumer a
utility of 20 units whereas an orange yields him a utility of 10 units. Therefore, it is clear
that the consumer gets twice as much utility from an apple as that from an orange.
Hicks and Allen defined the concept of ordinal utility. the utility cannot be measured;
According to them utility can not be measured and can only be compared. A person can
only compare the utility he gets from the first unit of orange with the utility he gets from
the second unit
e) Total Utility and Marginal Utility
There is no direct measurement to measure utility since it is a subjective term. Yet it
can be indirectly measured by price. Higher the price, higher the utility. This is
applicable for a single person alone and not for more than one person. Money is the rod to
measure the utility but with certain limitations. Utility derived from a commodity is the
basis of demand for the commodity. Ceteris paribus marginal utility and price are the two
determinants of the quantity demanded for the commodity.
Total utility is the amount of utility derived from the consumption of all the units of a
commodity at the disposal of the consumer. Economists measure utility in imaginary units
called utils. Marginal utility is the change in the total utility resulting from one unit
change in the consumption of a commodity.

Marginal utility =

Changes in the total utility

; MU
Changes in the unit consumed

TU

Qx

15

THEORY OF CONSUMER BEHAVIOUR

The theories of consumer behaviour are concerned with the decision-making behaviour
of the consumer. The central theme of the traditional theory of consumer behaviour is
consumers utility maximizing behaviour. The fundamental postulate of the consumption
theory is that a consumer-an individual or a household-is a utility maximizing entity and all
his decisions are directed towards maximization of his total utility, given his resources and
market conditions.
The theory of consumer behaviour has two aspects viz., Aggregative aspect and
Expenditure aspect. The aggregative aspect belongs to macro economics. The expenditure
aspect of the theory has two main approaches. They are;
i) Marginal utility approach and
ii) Indifference curve approach
f) Law of Diminishing Marginal Utility
This law indicates the familiar behaviour of marginal utility, i.e., as a consumer takes
more and more units of a good, the additional satisfaction that he derives from an extra unit
of the good goes on falling. Marshall stated the law of diminishing marginal utility as
follows:
The additional benefit which a person derives from a given increase of his stock
of a thing diminishes with every increase in the stock that he already has.
Let us suppose that a consumer takes 8 units of mango one after another. The utility he
gets from the second unit of mango will be lesser than the utility he gets from the first unit.
Thus, the marginal utility from successive units of mango will tend to decline. It could be
observed from Table that the total utility increases at diminishing rate. When the marginal
utility becomes negative, the total utility starts decreasing. This is illustrated in Figure 2.1.
Why does MU decrease?
1. Each particular want is satiable
2. Goods are imperfect substitutes for one another and they tend to be consumed in
appropriate proportions.
3. Utility depends on the degree of intensity of its need. The successive units reduce the
intensity of need thus reduce the utility derived from it.
Fig 2.1 Diminishing Marginal Utility
80

TU

total & Marginal utility

70
60
50
40
30
20
10

0
-10 0

4
6
Mango consume d

10

Rational behaviour:
The rational behaviour is to get maximum satisfaction

Table 3.1Total
Utility
Mango
TU
0
1
2
3
4
5
6
7
8

and Marginal
MU
0
30
50
60
65
67
67
64
58

30
20
10
5
2
0
-3
-6

16

Equilibrium Condition:
If MU is > Price he will buy more of the commodity
If MU is < price he will buy less commodity
When MU = price he will stop purchasing and he is said to be in equilibrium condition.
If the marginal utility from the commodity is greater than the price he has to pay, he will
buy more of the commodity. If the marginal utility is less than the price, he will buy less of
the commodity. If marginal utility is equal to the price of the commodity he will stop his
purchase of the commodity. Hence the marginal utility is measured in terms of money.
Assumptions
1. Consumer is rational. i.e. he buys first a commodity which yields highest utility and the
last which gives the least utility.
2. Taste and money income remains the same.
3. Maximum satisfaction is the main goal.
4. Utility can be absolutely/cardinally measured.
5. Utility is additive. Total utility of all the goods consumed can be obtained by adding the
utility of each and every commodity.
6. Marginal utility of the money remains the same.
7. Price of the substitute goods remains the same.
8. No new substitute for the commodity has been found out.
9. Units of particular commodity are identical.
10. The entire process of consumption is finished at one and the same time.
Limitations
This law is not applicable
1. In case of hobbies such as collection of stamps and old coins. Here the desire to acquire
more and more is common.
2. In case of misers who wants to have more and more money.
3. In a rich people zone, where all are having two cars except one person. This person will
have more desire to have the second car than for the first car.
4. In case of consuming liquor the MU of liquor instead of diminishing actually rises with
increased consumption.
Applications / Importance
1. Law of Demand, Law of Substitution, Concept of Consumers Surplus, Elasticity of
Demand are based on this law.
2. The downward sloping of demand curve is explained by this law
3. This law helps in regulating our expenditure. Larger purchase means lower MU and so.
If the purchase are made in such a way that MU = Price, then the satisfaction will be
more.
4. Since the MU of money to rich people will be lesser than poor people, the progressive
system of taxation can be imposed on them and this is implicit from this law
5. It forms the basis for theory of value (i.e. as supply increases the value decreases) to
determine the price.
6. It also explains the divergence between value in use and value in exchange. Air has
greater utility (value in use) but little value in exchange because it has no marginal
utility since it is abundant in nature. (In case of Diamond it is extremely opposite to it)
g)

Marginal Utilities of Related Goods

Goods may be substitutes or complementary in nature. The substitutes
are capable of satisfying the same want, (E.g.) tea and coffee. If they are

17

perfect substitutes, they may be treated as one commodity for all practical
purposes. But most goods are imperfect substitutes. In case of such goods,
other things being equal, the marginal utility of any such good (mango)
decreases, as the quantity of its substitute (orange) with the consumer
decreases.
If Complementary goods are such goods that are wanted together for the
satisfaction of a want, (E.g.) bread and butter. In such cases, other things
remaining the same, marginal utility of one good decreases, as the quantities of
its complementary good with the consumer increases. If, for instance, a
consumer wants to take more bread, the marginal utility of butter goes down.
h) Law of Equi - Marginal Utility or Law of Substitution or Law of Maximum
Satisfaction
If a consumer purchases more than one commodity with a give income level, he applies
the law of equi-marginal utility to attain maximum satisfaction. Marshall stated this law as
follows:
If a person has a thing which can be put to several uses, he will distribute it
among these uses in such a way that it has the same marginal utility in all.
According to this law, a consumer distributes a given quantity of any commodity
among its various uses in such a manner that its marginal utility in all uses is equal. Such a
distribution of the commodity will secure the consumer the maximum satisfaction.
If there is no limit on income to be spent then the consumer would decide to purchase
the goods till each of them yield zero marginal utility. Thus it is seen that the distribution
of the limited means between different uses will yield maximum utility when the marginal
utility is equal in all uses.
The principle of equi-marginal utility can be express as
MU of X
MU of Y
MU of Z
=
=
Price of X
Price of Y
Price of Z
This condition the consumer is stated to be in equilibrium in consumption. Assume
marginal utility of money constant, at OM, the marginal utility derived in
purchasing 3 units of mango is equal to purchase of 5 units of orange. This
indicated that mango has valued more.
Fig 2.2 Equilibrium under law of Equimarginal
utility

Table 3.1 Law of equi-marginal utility

12
10

Orange (x)
M

A
B

MUi/Pi

Px=2

Mango (y) Py=3

Unit
1

TUx
20

MUx
20

MUx/P x
10

TUY
24

MUy
24

MUy/Py
8

38

18

45

21

54

16

63

18

68

14

78

15

80

12

90

12

90

10

99

Orange
6
4

Mango
2
0

O0

Orange/Mango (Nos)

MUx/Px

MUy/Py

18

Importance of the law

With all these limitations, the law of equi-marginal utility is considered to be an
important law in economics for the following reasons.
1. It applies to consumption
The consumer gets maximum satisfaction through the substitution of a commodity with
greater utility for the one with less utility.
2. It applies to production
The producer/manufacturer will produce most economically by substituting one factor
for another till their marginal productivities are equal.
3. It applies to exchange
Exchange is nothing but substituting one thing for another. The scarcity of commodity
is reflected through rising prices in a market. This law helps in readjustment of
resources and adjustment of demand and supply by substitution.
4. It applies to distribution
In distributing the rewards of four factors their shares are determined by the principle of
marginal productivity. The producer will get maximum profit by equalizing the
marginal productivities of the factors of production with the help of equi-marginal
utility. Marginal product is the addition made to total product when one more unit of a
factor is used.
5. It applies to public finance
The principle of maximum social advantage involves the law of substitution and it
proposes that the revenue must be distributed in such a way that the last units of
expenditure beings equal welfare and satisfaction to all classes of people.

Critical evaluation of marginal utility analysis:

1. Cardinal measurement of utility is not possible.
2. Marginal utility of money does not remain constant.
3. The Psychological law of diminishing marginal utility has been established by
introspection. This law is accepted as an axiom without empirical verification.
4. Hypothesis of independent utilities is wrong. (Complementary substitutes) since it
ignores cross effects.
5. Marginal utility analysis does not split up the price effect into substitution and income
effect and so could not explain Giffen Paradox.
6. The assumption that consumers buy additional units of same commodity when the price
falls is not always correct.
7. Since this analysis makes so many assumptions this is otherwise referred as an
inadequate and unrealistic analysis.

19

Lecture -4
Ordinal approach - Indifference curve characteristics budget line equilibrium of
consumer.
INDIFFERENCE CURVE ANALYSIS
Indifference Curve analysis seems to have been Conceived by F.Y. Edgeworth
(1881) and it was followed by Irvin Fisher (1982). It was further developed by Vilfredo
Pareto (1906) to develop his own Theory of value and was followed by Slutsky (1915) and
Hicks and Allen (1934) in an article entitled on A reconsideration of the theory of value,
and his book on Value and capital (1939).
Marginal Rate of Substitution (MRS) is the basic concept.
Diminishing marginal rate of substitution is the fundamental law.
Utility Analysis is a flow since:
1. Utility cannot be measured cardinally but compared in ordinal terms.
2. Marginal utility of money never remains constant.

INDIFFERENCE CURVE
An Indifference Curve (IC) may be defined as the locus of points each
representing a different combination of goods, which yield the same utility or level of
satisfaction to the consumer so that he is indifferent between any two combinations of
goods when it comes to make a choice between them. They are also called as Isoutility
curves / Equal utility curves)
Indifference Curve may also be defined as the locus of the various combinations of
the commodities, which yield the same level of total satisfaction to the consumer.
Indifference Curve can be drawn from an Indifference Schedule. Indifference Schedule is
a schedule/tabular statement, which shows the various combinations of goods that will be
equally satisfactory to the individual concerned. If we depict this in the form of a curve we
get Indifference Curve map.
The consumer can arrange goods and their combinations in the order of
their level of satisfaction. This mutual arrangement of combination of goods
and services set in order of the level of significance is called scale of
preference. This scale of preference is based on individual tastes, habits etc.
Based on this scale of preference Indifference Curve can be developed.
Table 4.1 Marginal Rate of Substitution
Commodity Y

Combin apple
ation

IC3
IC2
IC1
Commodity X

Fig 2.3 Indifference Curve Map

Orange

MRS of apple
for orange

15

11

4:1

3:1

2:1

1:1

The quantity of one commodity is decreasing while another is increasing since the
consumer is to remain at the same level of satisfaction. We cannot measure the satisfaction
absolutely but it can be expressed relatively. The consumer is indifferent in all
combinations since all are giving the same level of satisfaction.

20

If all this combination are plotted and joined to form a smooth curve it will give an
Indifference Curve at a level of total income.
Thus, a collection of Indifference curves where each curve shows a certain level of
satisfaction to the consumer without intersecting or touching other is indifference map.
From this map one can infer whether one Indifference Curve represents a higher or lower
level of satisfaction than another but one cannot say by how much satisfaction is higher or
lower.

Marginal Rate of Substitution (MRS)

The rate at which one commodity can be substituted for another without changing
the level of satisfaction is called MRS.
Diminishing MRS
The number of units of a commodity a consumer is willing to sacrifice for an
additional unit of another goes on decreasing when he goes on substituting one commodity
for another.
MRS of y for x =

Y
replaced good Y
when X is substituted for Y; (OR) MRSxy=
X
added good X

Why does MRS diminish?

Since goods are not perfect substitutes for each other the subjective value attached
to the additional quantity of a commodity decreases fast in relation to the other commodity
whose total quantity is decreasing.
Therefore when the quantity of one commodity [say X (apple)] increases and that of
the other [say Y (Orange)] decreases, it becomes increasing difficult for the consumer to
sacrifice more units of commodity Y for one unit of X. But if he is required to sacrifice
additional units of Y he will demand increasing units of X to maintain the level of his
satisfaction. As a result, MRS decreases.

Assumptions
1) Rationality: Consumer wants to maximize his total satisfaction given his income and
prices of goods and services he consumes.
2) Utility can be expressed only ordinally
3) Transitivity and consistency of choice. If A > B and B > C then A > C is transitivity
and If A > B in one period, then B>A or B =A in another period indicate the
inconsistency.
4) Non-satiety: Consumer is not over supplied with either goods. i.e. he has not reached
the point of saturation. Therefore a consumer always prefers a larger quantity of all the
goods.
5) Diminishing MRS
PROPERTIES OF INDIFFERENCE CURVE (IC)
1) Downward - sloping from left to right
The negative slope of Indifference Curve implies that the
a) Two commodities can be substituted for each other
b) If quantity of one commodity decreases, quantity of other commodity must increase if
the consumer has to stay at the same level of satisfaction.

21

If it would be positive slope the consumer is equally satisfied with larger & smaller
baskets of X and Y. If it would be vertical - one commodity (Vertical axis) goes on
increasing and other (X axis) remains the same and so the satisfaction will goes on
increasing. If it would be horizontal the above case is vice versa.

2) Indifference curves are convex to origin

The convexity of the Indifference Curve implies not only that the two commodities
are substitutes for each other but also MRS between the goods decreases as a consumer
moves along an Indifference Curve. This is due to diminishing MRS. It happens so because
a) X and Y are not perfect substitutes for each other
b) MU of a commodity increases as its quantity decreases.

3) Upper Indifference Curve represents a higher level of satisfaction than lower ones
An Indifference Curve placed above and to the right of another represents a higher
level of satisfaction than the former one. Upper Indifference Curve contains all along its
length a larger quantity of one or both the goods than the lower Indifference Curve and a
larger quantity of a commodity is supposed to yield a greater satisfaction than the smaller
quantity of it provided MU > 0.

IC

Commodity Y

IC

Commodity Y

Commodity Y

4) Indifference Curve neither Intersect nor Touch each other

If two Indifference Curves intersect each other, it implies that an Indifference Curve
indicates two different levels of satisfaction or two different combinations yield the same
level of satisfaction. This is impossible if the above property (3) is valid.

IC

Commodity X
Commodity X
Commodity X
Fig.4.1 (a) Horizontal IC
Fig.4.1 (b) Vertical IC
Fig.4.1(c) Upward IC
Budget line
The graphical line indicating all those different combinations of the two
commodities that the consumer can actually purchase with his given income and a taste is
called budget line or price line.
Equilibrium of the consumer
In Indifference Curve approach the equilibrium position of the consumer is
achieved under following assumptions.
1) The consumer has given Indifference Curve map showing his scale of preference,
which remains the same throughout the analysis.
2) The consumer has a fixed amount of money income.
3) He wants to buy a combination of two goods, say X and Y.
4) Prices of X and Y remain constant.
5) The goods X and Y are divisible so that various combinations of two goods can be
had.
6) Tastes and preferences of the consumer remain the same.

22

7) The consumer seeks maximum satisfaction.

PRICE LINE

Price Line

Commodity X
Fig. 4.2 Price Line or
Budget Line

Commodity Y

R
EQUILIBRIUM
POINT (E)
IC 4

IC 3
S

IC 2
IC 1

M
L
Commodity X
Fig. 4.2 Consumers Equilibrium

Equilibrium of the consumer

This is achieved only at the point at point E which his budget line is tangent to
the Indifference Curve (IC2). The Indifference Curve should be of the higher order in the
consumers scale of preference within his reach. At this equilibrium point MRSx y = Px
/Py (MRS and price ratio is equal).

Applications:
1) To measure Consumers surplus
2) To study producers Equilibrium (Maximum output)
3) To determine the rate of exchange between two commodities bartered by two
individuals.
4) To analyze both direct and indirect tax issues.
5) To analyze the effects of subsidies to consumers with meager incomes.
Superiority of Indifference Curve Analysis over Marginal Utility Analysis
1) It adopts ordinal measurement of utility in a more realistic way.
2) It introduces the concept of MRS, which is measurable
3) It takes cross effects into account
4) It clearly brings out the distinction between income & substitution effect
5) Unrealistic assumption of constant MU of money is avoided
6) It has fewer assumptions

Critical evaluation
1) Property of convexity to the origin of Indifference Curve is highly disputable
2) Indifference Curve is based on the wrong/unrealistic assumption that the consumer is
familiar with his entire preference schedule.
3) This Indifference Curve approach will be more complicated one if more than two
commodities is concerned
4) It is limited empirical in nature.
Due to the above limitations it is otherwise called as old wine in a new bottle
(Robertson) since the old concepts of Marginal Utility Analysis are replaced by new
concepts in Indifference Curve Analysis. For example Utility is replaced by preferences,
one, two, three is replaced by first, second, third, MU is replaced by MRS and
Proportionality rule is replaced by equality between MRS & Price Raito.

23

Questions for Review:

1.Fill up the blanks with appropriate words given in the brackets:
a) A good with negative utility has -------- (use/no use).
b) Wants --------- over time (change/do not change).
c) Free goods are ------------- (scarce/not scarce).
d) Indifference curves are ------------- to the origin (concave/convex).
e) Gold ornaments are ------------- goods (luxurious/comforts).
f) The consumer attains equilibrium when marginal utility equals -------- of
the commodity.
g) According to indifference curve analysis, the consumer ranks the
combinations of commodities using his ---------- .
2.Differentiate the following:
a) Perishable and durable goods.
b) Cardinal and ordinal measure of utility.
c) Income and wealth.
d) Consumer goods and producer goods.
e) Real income and money income.
f) Free good and economic good.
g) Utility and value.
f) Satisfaction and utility.
3.Answer the following:
a) What are the characteristics of human wants?
b) Explain the different types of wants.
b) State and explain the law of diminishing marginal utility.
c) Explain the assumptions of the law of diminishing marginal utility.
d) Explain the importance of the law of diminishing marginal utility.
e) Define the law of equi-marginal utility. How consumer gets maximum
satisfaction?
f) Define the indifference curve. Explain the properties of indifference curves.
g) How the consumer gets maximum satisfaction with indifference curve
analysis?
h) What are the defects of utility analysis? How indifference curve analysis
can remove them?

24

DEMAND

Lecture 5
Demand Individual Demad Market Demand Demand Schedule Demand
Curve Law Of Demand And Factors Affecting It

The demand for a commodity is defined as a schedule of the quantities that buyers
would be willing and able to purchase at various possible prices per unit of time. Unit of
time refers to year, month, week and so on. It should also be understood that demand is not
the same thing as desire or need. A desire becomes demand only when it is backed up
by the ability and willingness to pay.

Demand may be defined as the quantity of a commodity desired and purchased by a

person at a given point of time at a given price.
A. i) Demand Schedule
An individuals demand schedule is a list of various quantities of a commodity, which
an individual consumer purchases at different (alternative) prices in the market at a given
time. The demand schedule, thus, states the relationship between the quantity demanded of
a commodity and its price. In a market, there are a number of consumers each with his own
demand schedule, showing the different quantities of the commodity that he will purchase
at different prices. The market demand schedule can be obtained in two ways.
1. By adding up the demand schedules of all the consumers in the market.
2. By taking the demand schedule of the representative consumer and multiplying it
by the total number of consumers in the market.

Table 5.1 Demand Schedule for Rice in Tiruchirappalli Market

Price of rice (Rs/qt1)

Quantity of Rice Demanded

(tonnes per month)

950

5000

900

5100

850

5200

800

5300

750

5400

700

5500

Determinants of Demand
1. Price of the commodity
If the price of the commodity increases demand for that commodity decreases (Inverse
relationship).
2. Income of the consumer
As Income increases demand also increases (Positive relationship) In case of Essential
consumer goods such as food grains, Normal goods such as cloth and Luxury goods such
as cars there exists positive relationship and in case of Inferior goods the relationship is
negative.
3. Consumers tastes and preferences
As there is an economic development there is a shift from cheaper old fashioned goods
over to costlier modern goods even if virtual utility is same in both cases.
Bi-Cycle => Motor Cycle => Car

25

4. Availability of substitutes and their comparative prices

In case of substitutes (Tea & Coffee), If price of coffee increases its demand decreases
but the demand for tea increases even at same price. In case of complementary goods
(Bread and butter), if price of bread increases its demand decreases and so the demand
for butter also decreases.

5. Weather and climate conditions

During summer demand for Cool drinks and Ice cream increases, while demand for
warm cloths increases during winter.
6. Size and composition of consumers: (Positive relationship)
Ceteris paribus if the number of consumers increases the demand also increases. Again
if children are more among the population demand for toys will be more
7. Expectations on future prices: (Positive relationship).
If consumers expect a rise in the price of a commodity in future the current demand for
it will be more and vice versa. Similarly this concept may apply to income also.
8. Level and distribution of Income
If income is distributed equally, then demand for consumer goods will be increased
and vice versa.
9. Demonstration facility: (Positive relationship)
10. Consumer credit facility: (Positive relationship)
Law of Demand
The law of demand states that other things remaining constant, the quantity of a
product demanded per unit of time increases when its price falls and decreases when
its price increases, other factors remaining constant.
So an inverse relationship exits between price and demand.
The law of demand can be illustrated through a demand curve (Fig.3.1).
Suppose, the consumer purchases OQ 0 quantity of rice for OP 0 . If price of rice
rises from OP 0 to OP 1 the quantity demanded decreases from OQ 0 to OQ 1 .
Similarly, if the price falls from OP 0 to OP 2 , the quantity demanded rises from
OQ 0 to OQ 2 . Thus, there is a negative relationship between the price and
quantity demanded. In other words, the demand curve slopes downward from
left to right. The law of demand can be expressed in the functional form as
follows:

P1

Price of Rice

A
P0
P2

0
Q1 Q0
Q2
Quantity of Rice Demanded
Fig.5.1 Law of Demand

Qd = f (P, I, PR/T)
Where,
Qd = Quantity demanded of a commodity
P = Price of the commodity
I = Income of the consumer
PR = Prices of the related goods
T = Tastes and preferences of the
consumer

26

Ceteris paribus assumptions

1. Taste and preferences of the consumer remains constant.
2. Consumer income is fixed and constant.
3. Prices of substitutes and complementaries remain constant.
4. Climate and weather conditions remain unchanged.
5. There exists perfect competition.
The demand curve may be drawn from demand schedule.
Extension and contraction of Demand
If the quantity demanded increases due to a decrease in price, Ceteris paribus it is
called extension of demand. If the quantity demanded decreases due to an increase in price
it is called contraction of demand. Both will take place in one and the same curve.
Increase in Demand
When the quantity demanded increases due to changes in any factor other than price it
is called increase in demand and the demand curve shifts upwards in this case.
Decrease in Demand
When the quantity demanded decreases due to changes in any factor other than price it
is called decrease in demand and in this case the demand curve shifts downwards.
D1

D2

Price

D0

P1
P0

D2

P2

D0

OQ 0 - OQ 1 -Contraction of demand
OQ 0 - OQ 2 -Extension of demand
OQ 0 - OQ 4 -Decrease in demand
OQ 0 - OQ 5 -Increase in demand

D1

Q4 Q1Q0 Q2 Q5
Quantity Demanded
Fig5.2 Law of Demand

a. Why demand curve slope downwards?

When price falls more commodity is purchased because, as price falls,
1) A person can buy more goods as his real income increases and this is income effect.
2) As the commodity is cheaper it can be substituted for other goods and this is
substitution effect. Both this effects combine and makes the consumer to buy more.
3) The commodity can be put into more uses or less urgent uses when it becomes cheaper
eg. Water. Thus old buyers buy more and some new buyers enter the market.
4) Law of equi marginal utility (Marginal utility = price ratio) operates.
5) Law of diminishing marginal utility operates.
b. Why does the Law of Demand operate?
Now, an important question is: why the demand curve slopes downward, or in other
words, how the law of demand describing inverse price-demand relationship is valid?

27

There are three reasons for the operation of the law. Firstly, the law of demand is operated
because the law of diminishing marginal utility comes into force when a consumer buys
additional quantities of a particular commodity.

Exceptional Demand Curves

1) Upward slope Giffen goods
This was investigated by Robert Giffen and such goods are known as Giffen goods.
Giffen goods are normally inferior goods and it may be any commodity much cheaper than
its substitutes, consumed mostly by the poor households as an essential consumer good.
Thus the poor people mostly in under developed countries spent a major portion of their
income to buy a certain amount of these cheaper foodstuffs. When the price of such items
is low they will buy a little of more expensive superior foodstuffs.
But when the prices of cheaper food stuffs goes up they were forced to reduce their
expenses not on the cheaper food stuffs but on more expensive food stuffs, and, thus, make
up the deficiency by purchasing more of the cheaper food stuffs despite the fact that their
prices have gone up because they are still the cheaper food items. The poor people do this
because this is the only way in which they can secure the same amount of food as before
without increasing their expenditure on food.
All Giffen goods are inferior goods but all inferior goods are not Giffen goods.
In case of Giffen goods the income and quantity demanded are negatively
correlated. Sir Giffen discovered the fact that with an increase in the price of bread the
working class families of Britain were compelled to curtail their consumption of meat in
order to be able to spend more on bread.

2. Status symbol commodity (Veblen effect)

If a commodity confers distinction the wealthy people buy more when price
increases to be included among the few distinguished personages eg. Diamonds. If the
price falls so that even a poor can also buy it and so it no longer confer any prestige/social
distinction they may cut their purchases.
3. Speculation: If the price of commodity is increasing and is expected to increase still
further the consumer will buy more of the commodity at the higher price than they did
at the lower price.
4. When a serious shortage is feared, people get panic and buy more even though the price
is rising. This is exceptional rise in prices.
5. Sometimes people buy more at a higher price in sheer ignorance.
6. Sometimes the quality of certain products such as cosmetics, creams, lipsticks, powders
are judged by its high price. Consumers buy more of these products at higher than at
lower prices.
Market Demand
Price demand refers to various quantities of a commodity that consumers demand
per unit of time at different prices, assuming their income, tastes, and prices of related goods
remain unchanged.
The demand of the individual consumer is called individual demand and total
demand of all the consumers combined for the commodity /service is called market demand.
Thus the market demand for a commodity is the total of individual demands by all the
consumers of the commodity per unit time at a given price while other factors are held
constant.

28

For instance, suppose there are 3 consumers and the demand curves for them for
the commodity X are Da, Db and Dc respectively. Now the market demand curve can be
obtained by adding together the amounts of the good, which individuals wish to buy at each
price.
This can be obtained by horizontal summation of Da, Db and Dc and that results
in Dm for the commodity X. The curve Dm represents the market demand curve for
commodity X when there are only 3 consumers of the commodity.

Consu mer A

Market
Consumer B

Consumer C

Quantity DD

Da

Db

Dc

Fig 5.3 Market Demand

Thus at price P, the individual A wish to buy Oa amount of the good, individual B Ob
amount of good and individual C Oc amount of good. The total quantity of good that all
the 3 individuals plan to buy at price P, is therefore Oa + Ob + Oc, = Oq and this is
called market demand at P, for commodity X . Thus the market demand is the
horizontal summation of individual demand curves.

iv) Types of Demand : There are three different types of demand which are
discussed below:
a) Price demand : Price demand refers to various quantities of a commodity
that consumers demand per unit of time at different prices, assuming that
their incomes, tastes and preferences and prices of related goods remain
constant. The law of demand explains to price demand.
b) Income demand : Income demand refers to the different quantities of a
commodity which consumers will buy at different levels of income, other
things remaining the same. Other things, here, refer to price of the
commodity, prices of related goods and tastes and preferences of the
consumer. As income of the consumer increases, his demand for a normal
or superior commodity also rises. Thus, there is a positive relationship
between income and quantity demanded. The income demand curve slopes
upward from left to right. For inferior goods, the quantity demanded will
be more, if income of the consumer declines, while other determinants of
demand remain constant and vice versa. Thus, the income demand curve
slopes downward and it indicates that there is an inverse or negative
relationship between income and quantity demanded.

29

D
I1

I1

I0

I0

Income

Income

Qo
Q1
0 Q1 Q0
Quantity Demanded
Quantity Demanded
Fig. 5.4(a) Income Demand for
Fig. 5.4(a) Income Demand
c)a Cross
demand:
It refers
to the different quantities
of a commodity
Normal
or Superior
Good
for an Inferior
Good that
0

D
P0

Price of Tea

P1

Price of Bread

consumers purchase per unit of time at different prices of a related commodity,

other things remaining the same. The other things, here, include consumers
income, his tastes and preferences and the price of the commodity itself. The
related commodity may be either substitute or complementary good. For
example, tea and coffee are substitutes.
D

P1

0
Q0
Q1
Quantity Demanded of Coffee

P0

0
Q1
Q0
Quantity Demanded of Butter

Fig.5.5 (a) Demand for Substitute Good.Fig.5.5 (b) Demand for Complementary Good

Substitutes satisfy the same want. If the price of tea rises, the consumer
buys less of it. Instead, they may buy more of coffee. Thus, a rise in the price
of tea increases the demand for coffee. The cross demand curve of coffee in
relation to the price of tea will have a positive slope (or, slopes upward to the
right). On the contrary, if both the commodities are jointly demanded to satisfy
the same want they are called complementary goods. For example, bread and
butter are complementary goods. A fall in the price of bread will increase the
demand for butter and vice-versa. The cross demand curve of butter in relation
to the price of bread will have a negative slope (or slopes downward to the
right).
Complementary demand is also known as Joint demand . Joint demand
takes place when two or more goods are jointly demanded for the satisfaction
of a particular want. E.g. bread and butter, shoes and shoe-laces, cup and
saucer, tea, milk and sugar, etc.

d) Derived demand is other types of demand. The demand for a factor of

production that results from the demand for the final form of the commodity

30

which it helps to produce. For example, a consumer buys bread. To bake the
bread, bakers have to buy flour. Their derived demand for flour is met by flour
mills. The flour mills in turn, buy wheat; their derived demand goes back to
the farmers who grow the wheat. The farmers, in turn, have a derived demand
for seeds, fertilizers, tractors etc. to cultivate wheat.

31

Lecture 6
Elasticity Of Demand- Price, Income And Cross Elasticities Estimation Point
And Acr Elasticities Giffen Good- Normal And Inferior Goods Substitutes And
Complementary Goods

B. ELASTICITY OF DEMAND
Elasticity of demand refers to the sensitiveness or responsiveness of
demand to changes in price. Price elasticity of demand is usually referred to as
elasticity of demand. Also, there are income elasticity of demand and cross
elasticity of demand.

i) Price Elasticity of Demand

It is the ratio of proportionate change in quantity demanded of a
commodity to a given proportionate change in its price. Price elasticity of
demand (E P ) is, thus, given by:
P e r c e n ta g e c h a n g e
P e r c e n ta g e
Q
Q
x1 0 0
Q
Q
Ep =
=
=
P
P
x1 0 0
P
P

Ep=

in q u a n ti ty d e m a n d e d
c h a g e in p ri c e

Q
P
Q
P
x
=
x
P
P
Q
Q

Where, Q = quantity demanded of a commodity; P= Price.

Let us suppose that a consumer demands 10 oranges when its unit price is
Re. 1(100 paise). If its price falls to 95 paise, he demands 12 oranges. Now,
the
price
elasticity
is
of
demand
can
be
estimated
as
2 100
follows Ep = ( x
) = (4) = 4 . Getting the positive number multiply with
5 10
minus, because the inverse relationship between price and quantity demanded
gives always gives price elasticity with negative sign.
As the price falls by 5 per cent, the quantity demanded raises by 20 per
cent. Now, the coefficient of elasticity of demand is minus 4. Thus, it could be
concluded that there is a four per cent increase in the quantity demanded of
orange due to one per cent decrease in its price.

a) Types of Elasticity of Demand: Price elasticity of demand is classified

under the following five sub heads:
1. Perfectly elastic demand: It refers to the situation where the slightest
rise in price causes the quantity demanded of a commodity to fall to zero and
at the present level of price people demand infinitely large quantity of the
commodity. The coefficient of elasticity of demand is infinite.
2. Perfectly inelastic demand : It refers to the situation where even
substantial changes in price do not make any change in the quantity demanded,
i.e., for any change in the price, the demand remains constant. The coefficient
of elasticity of demand is zero.

Price

Price

32

ns
u

Ep = 0

P
Ep =

Q0 Q1
Quantity Demanded
Fig. 6.1(a) Perfectly Elastic

Q0
Quantity Demanded
Fig. 6.1(b) Perfectly Inelastic

3. Relatively elastic demand: Here, a small proportionate change in the price

of a commodity results in a larger proportionate change in its quantity
demanded. The coefficient of elasticity of demand is greater than unity.
4. Relatively Inelastic demand: A larger proportionate change in the price of
a commodity results in a smaller proportionate change in its quantity
demanded. The coefficient of elasticity of demand is greater than zero, but less
than unity.
5. Unitary elastic demand: It refers to a situation where a given proportionate
change in price is accompanied by an equally proportionate change in the
quantity demanded. In other words, a given proportionate fall in the price is

P0

0
Q0
Q1
Quantity Demanded
Fig.6.2(c) Relatively Elastic

P0
0 < Ep < 1

P1

0
Q0 Q1
Quantity Demanded
Fig.6.2 (d) Relatively
Inelastic

Ep=1
P1

Price

Ep > 1

P0
P1

Price

Price

followed by an equally proportionate increase in demand and vice versa. The

coefficient of elasticity of demand is unity.

0
Q0 Q1
Quantity Demanded
Fig.6.2 (e) Unitary
Elastic

b) Factors Influencing the Elasticity of Demand: The elastic or inelastic

nature of the demand for a commodity is determined by the following factors.
1) Degree of necessity: Other things being equal, the demand for
necessities is inelastic or less elastic than that for comforts and luxuries. The
reason is simple. The necessities must be bought whatever be the price because
no one can live without them. The demand for a necessity without a substitute
is less elastic than the demand for a necessity with a substitute. For example,
the demand for salt is less elastic than that for paddy.

33

2) Proportion of consumers income spent on the commodity: The

demand for a commodity on which the consumer spends only a small
proportion of his income is less elastic. For instance, even if the price of salt
or match-box rises by 100 per cent, the demand for them may not decline
substantially.
3) Existence of substitutes: The demand for a commodity is more elastic,
if it has a number of good substitutes. A small rise in the price of such a
commodity will induce the consumers to go for its substitutes, assuming that
their prices do not rise.
4) Several uses of the commodity: The demand for a commodity is said to
be more elastic, if it can be put to a variety of uses. A fall in the price of
electricity will result in the substantial increase in its demand.
5) Time: The elasticity of demand varies with the length of time. In
general, demand is more elastic for longer period of time. For instance, if the
price of kerosene rises, it may be difficult to substitute it with cooking gas
within a very short time. But if sufficient time is given, people will make
adjustments and use firewood or cooking gas instead of kerosene.
c) Measurement of Elasticity of Demand: Price elasticity of demand can be
measured by three methods. They are:
1) Total Expenditure or Outlay Method
2) Measuring Elasticity at a Point
3) Arc Method
1) Total Expenditure or Outlay Method
In this method, the total expenditure on the quantity of a commodity
demanded is used to find out whether the total expenditure has increased or
decreased or constant, consequent on the changes in its price. In the first case,
consequent on the fall in price from Rs.6 to Rs.5 and then to Rs.4, the
quantities demanded have increased to 1500 and 2000 respectively.

Table 6.1 Elasticity of Demand Total Outlay Method

Sl. No.

price ('000
Rs/qtl)

Qty DD

Total outlay
'000 Rs

Ep=price elasticity of DD

1.50

3.00

4.5

-2.00

1.25

4.00

-1.25

1.00

5.00

-1.00

0.75

6.25

4.6875

-0.60

0.60

7.00

4.2

-0.43

0.50

7.50

3.75

Ep=>1
Ep=1
Ep<1

Due to fall in price, the total outlay has gone up. So, when the total outlay
increases due to fall in price the demand is elastic. In the second case, total
outlay remains constant irrespective of changes in prices and hence the demand is
of unit elasticity.

34

In the third case, total outlay decreases with the fall in price. So, it has
inelastic demand. In the figure 3.9, ab portion of total expenditure curve slopes
downward showing, as the price falls, the total expenditure is increasing and vice
versa. So, the demand at this price range is elastic and ep is greater than 1. Over
the price range from op 2 to op 3 the total expenditure curve shows that as the price
falls, the expenditure decreases and as the price increases from op 3 to op 2 , the
total expenditure increases showing that the demand is inelastic and ep is smaller
than one. In the price range p 1 to p 2 , the total expenditure does not change. Hence,
the elasticity is unity and ep = 1.
Demand Curve

Total outlay Curve

Price ('000 Rs/Qtl)

2) MEASURING
ELASTICITY AT A POINT: IT IS A GEOMETRIC
1.6
METHOD
1.4

Proportionate change in quantity demanded

Ep= 1.2
Proportionate change in Price
1
Q 0 Q 1 P0 P1 R K 1
RK 0
Ep= 0.8

=
OQ
OP0 O Q 0 Q 0 K 0
0.6 0
=

R0.4
K1 Q 0K 0
X
O Q 0 3 R K40

6.25

Qty DD (Qtl)

47.5

4.5

5.5

total outlay ('000 Rs)

Q 0K 0
RK1
=
XFig 6.3
Demand curve and total outlay curve
RK 0
OQ 0

In the figure 3.10, the triangle K 0 RK 1 is similar to triangle K 0 Q 0 T and,

therefore, we can substitute,

QT
QT QK
RK1
by 0 , now Ep= 0 x 0 0 Cancelling Q 0 K 0 on both sides, we get Ep
RK 0
Q0 K 0
Q 0 K 0 OQ 0
= Q 0 T /O Q 0 . The assumption is that a very small change in price and
quantities has been considered and so, points K 0 and K 1 on tT lie very close so
as to almost coincide. If this be the assumption, then Q 0 K 0 should coincide
with Q 1 K 1 and in right angled triangle tOT, the relation Q 0 T / OQ 0 can be
expressed as TK 0 / K 0 t. Since TK 0 is the lower sector of the demand curve at
this point and K 0 t is its upper sector, we can say that in a demand curve at any
point,

35

P
t

P0

K0

K1
P1
R
Qd
0

Q0

Q1

Fig.6.4 (a) Elasticity of

Demand: Point Method
K0T

Lower sector
Elasticity =

. That is, Elasticity at point K 0 =

Upper sector

K0t

At point K, in the Fig.6.4 (b), the lower and upper sectors are equal and hence,
at K, the demand is unitary elastic. And point below K, say L, will show
inelastic demand and any point above K, say M will show elastic demand. At
the point where the demand curve touches the X-axis, the value of Ep = 0
(perfectly inelastic) and at the point where the demand curve touches the Yaxis the value of Ep is (infinite) (perfectly elastic) .

3) Arc Method: The Point Method of Elasticity of demand studied above

refers to the condition where the price changes and in quantities demanded is
very small so that we can find out the elasticity at a point. Since the changes
are very little, we take the original price and quantity as the basis of
measurement. Suppose the change in price and quantity is very large, neither
the initial nor final price nor quantities can be taken.
Ep

Price
Quantity Demanded
(Rs/Kg)
(Kgs/Day)
Ep>1
30
200

20
400
Ep=1
M

In the above schedule, the elasticity

K

Ep<1 Ep=0 considering the initial price as the basis, is

200 30
Ep=
X
= 3 ; Instead, suppose we take final
L
200 10
price and quantity demanded as a base ,
0
T
200 20
Quantity Demanded
Ep=
X
= 1;
400 10
Fig.6.4 (b) Price Elasticity of
Demand: Point Method

Price

36

Now, there is a wide difference in elasticities, if we take initial or final

prices. Hence, arc elasticity of demand is used to solve this problem. For this,
the average of both initial and final prices and quantities are used.

Original Quantity - New Quantity

200 - 400
Original Quantity + New Quantity
Elasticity of Demand=
= 200 + 400 = 1.6
Original Price - New Price
30 - 20
Original Price + New Price
30 + 20
The Elasticity 1.67 is neither 1 nor 3. In order to measure arc elasticity
between points K and L on the demand curve DD, the formula will be:
D

Price

P1

Ep=
K
K

Q
P

Q1 + Q 2
P1 + P2
2
2

L
D

P2

Q
X
Q1 + Q 2
2
Q ( P1 + P2 )
=
P ( Q1 + Q 2 )

Q1
Q2
Quantity Demanded
Fig.6.5 Elasticity of
Demand-Arc Method

P1 + P2
2
P

d) Uses of Elasticity of Demand

1) The business firms take into account the elasticity of demand when they
take decisions regarding pricing of goods.
2) The elasticity of demand concept is used by the government in economic
policy regarding regulation of prices of farm products.

ii) Income Elasticity of Demand

It may be defined as the ratio of proportionate change in the quantity
demanded of commodity to a given proportionate change in income of the
consumer.

% Change in Quantity Demanded

% Change in Income
Q
X 100
Q
Y Q Y
Q
=
=
X
=
X
Y
Q

Y
Q
X 100
Y

Income elasticity Ei=

Where Q= quantity demanded and Y=income.

37

If, for instance, consumers income rises from Rs. 1000 to Rs. 1200, his
purchase of the good X (say, rice) increases from 25 kgs per month to 28 kgs,
then his income elasticity of demand for rice is:
3
1000
Ei =
x
= 0.60
200 25
From this, we conclude that, the quantity demanded of rice rises by 0.60
per cent, if the income of the consumer rises by one per cent. Income
elasticity of demand can be divided into following five sub-heads:

a) Types of Income Elasticity of Demand

1) Zero income elasticity: A given increase in the consumers money
income does not result in any increase in the quantity demanded of a
commodity (Ei=0).
2) Negative income elasticity: A given increase in the consumers money
income is followed by an actual fall in the quantity demanded of a commodity.
This happens in the case of economically inferior goods (E i < 0).
3) Unitary income elasticity: A given proportionate rise in the consumers
money income is accompanied by an equally proportionate rise in the quantity
demanded of a commodity and vice versa (Ei=1).
4) Income elasticity of demand greater than unity: For a given
proportionate rise in the consumers money income, there is a greater
proportionate rise in the quantity demanded of a commodity. Ei is greater than
unity. This is in case of luxuries.

5) Income elasticity of demand less than unity: For a given proportionate

rise in the consumers money income, there is a smaller proportionate rise in
the quantity demanded of a commodity. The income elasticity of demand is
less than

Income

I0

I0
Ei = 0

I1
Ei<0

I1

I1

I0
D

Q0

Ei=1
D

0
Q0
Q1
0
Q0
Q1
Quantity Demanded of a Commodity
Fig.6.6 (a) Zero Income Fig. 6.6 (b )Negative Income. Fig. 6.6 (c)Unitary
Elasticity of Demand
Elasticity of Demand Income Elasticity of Demand
unity in case of necessaries i.e., the percentage expenditure on necessaries
increases in a smaller proportion when the consumers money income goes up
(Ei < 1).

38

Lecture -7
Engels Law of family expenditure and significance. -Consumer's surplus
estimation and applications.

ENGELS LAW OF FAMILY EXPENDITURE

Standard of living
Standard of living is dependent on real income and not on money income. With an
increase in the real income the standard of living tends to increase.

Determinants of standard of living:

Standard of living depends on social or economic factors like the class
in which one is born, race, caste and community, besides factors such as a) Income of the
family b) Size and composition of the family and c) Price level of commodities.

Family budget
A list containing estimated expenditure of a family on each of this items is called
family budget.

b) Engels Law on Family Expenditure

Every family has to spend money on necessaries of life, education, health, clothing,
house rent, light and fuel, recreation and so on. A list containing expenditure by a family
on each of these items is called Family Budget. Earnest Engel (1857) made an
investigation on family budgets.
Engel considered that other things being equal, the best measure of the material
standard of living among a population was the proportion of the income spent on family
needs. The results of his study can be grouped into four laws. The laws are
commonly known as Engels law of family budget or consumption. They are
1.
As the family income increases, the percentage of income spent on food decreases,
although the actual amount increases.
2.
The percentage of income spent on clothing varies only slightly from rich to poor.
3.
The percentage of income spent for rent, fuel and light is invariably the same for
all the income groups.
4.
The percentage of income spent on education, recreation, health, etc., increases
as income increases, it almost vanishes in the case of low income group.
Engel made this study of percentage of expenditure on these items and not the amount of
money spent by different classes of people.

i) Implications of Engels law

1) The poor class people may find it difficult to spend on health, education and
recreation facilities, as they have to spend large amount on food and other
necessaries.
2) As the poor class has to spend more on food, any rise in the price or tax
levied on food would affect the poor more than the rich.
Thus a knowledge on standard of living will help in formulating
effective policies for the welfare of the people.

39

Table 7.1 Consumption Pattern in Different Sizes of Households

(Amount in Rs / Month)

Particulars

Small
Amount

Food

Middle

Percentage

Amount

Large

Percentage

Amount

Percentage

800

68

1392

58

1800

50

120

10

240

10

360

10

Fuel and lighting96

192

288

Education

12

72

180

Medical

26

120

252

Recreation

12

48

144

Social & Religious

functions
35

96

180

Services

96

180

216

100

3600

100

Clothing &
House rent

35

Others

45

Total

1181

100

144

2400

ii) Importance of Family Budget

1) Family budget studies help us to find out the consumption pattern of
people in different countries.
2) We are able to understand the trends in the cost of living of people.
3) The government can design its policies on prices, subsidies and taxes of
various commodities considering the standard of living of people in the
country.

iii) Cross Elasticity of Demand

The cross elasticity of demand may be defined as the ratio of proportionate
change in the quantity demanded of commodity X to a given proportionate
change in the price of the related commodity Y.

Cross elasticity Ec=

% Change in Quantity Demanded X

% Change in Price of Y
Qx
X 100
Qx
Py Qx Py
Qx
=
X
=
X
=
Py
Qx

Py

Py
Qx
X 100
Py

If the price of coffee rises from Rs 4.50 to Rs 5 per hundred grams and as
a result, the consumers demand for tea increases from 60 hundred grams to 70
hundred grams, the cross elasticity of demand can be estimated as follows:
Ec =

10 450 3
x
= = 1.50
50 60
2

40

It could be concluded that the quantity demanded of a commodity (tea)

increases by 1.5 per cent, if the price of its substitute (coffee) rises by one per
cent. Therefore, the cross elasticity of demand between the two substitute
goods is positive, that is, in response to the rise in price of one good, the
demand for the other good rises. Substitute goods are also known as competing
goods.
On the other hand, when the two goods are complementary with each other,
as in the case of bread and butter, the rise in price of one good brings about the
decrease in demand for the other. Therefore, the cross elasticity of demand
between the two complementary goods is negative. For example, if the price of
bread rises from Rs 6 to Rs. 7 per loaf, the quantity demanded of butter
decreases from 3 kgs to 2 kgs per month. The cross elasticity of demand for
butter is:
Q
E

Butter

Butter

x
P

B read

-1

Bread

=
Q

Butter

6
x

= -2
3

It could be concluded that the demand for butter decreases by two per cent
for one per cent rise in the price of bread.

C. CONSUMERS SURPLUS
The concept of consumers surplus is important in economic policies such
as taxation by the government and price policy pursued by the monopolist
seller of a product. The essence of the concept of consumer surplus is that a
consumer derives extra (or surplus) satisfaction from the purchases he daily
makes than the price he actually pays for them. This extra satisfaction, which
the consumer obtains from buying a good, has been called consumers surplus
by Marshall.
Thus, Marshall defines the consumers surplus in the following words:
Excess of the price which a consumer would be willing to pay rather than
go without a thing over that which he actually does pay, is the economic
measure of surplus satisfaction.

Hicks: It is the difference between the marginal valuation of a unit and the price, which is
actually paid for it.
The amount of money which a person is prepared to pay for a good
indicates the amount of utility he derives from that good; the greater the
amount of money he is willing to pay, the greater the satisfaction or utility he
will obtain from it. Therefore, the marginal utility of a unit of a good
determines the price a consumer will be prepared to pay for that unit. The
total utility which a person will get from a good will be given by the sum of
marginal utilities ( MU) of the units of goods purchased, and the total price
which he will actually pay is equal to the price per unit multiplied by the
number of units purchased. Thus:
Consumers surplus = What a consumer is prepared to pay
What he actually pays
= Sum of marginal utility - (Price x No. of units purchased)

41

a. Measurement of Consumers Surplus

1. Marginal Utility Approach
The concept of consumers surplus is derived from the law of
diminishing marginal utility. The consumer attains equilibrium position when
he purchases the number of units of a commodity at which marginal utility is
equal to the price. This means that at the margin what a consumer will be
prepared to pay (i.e., marginal utility) is equal to the price he actually pays.
But for the previous units, which he purchases, the marginal utility he gets
were greater than the price he actually pays for them.

Table 7.2 Consumers surplus

Units
Total Utility
surplus

Marginal Utility

Price(Rs/Unit)

Consumers

20

20

10

20-10 = 10

38

18

10

18-10 = 8

54

16

10

16-10 = 6

68

14

10

14-10 = 4

80

12

10

12-10 = 2

90

10

10

10-10 = 0

98

10

Rs. 30
This is because the price is constant. In the table 3.4, the consumer is in
equilibrium if he purchases 6 units of the commodity at which the marginal
utility and price of the commodity are same. Then, the consumers surplus is,
Rs.30 i.e., the difference between what he actually pays and what he is
prepared to pay, is equal to (90-60) = 30.
Consumers Surplus =Total Utility
D

Consumers
Surplus

---

Number of Units of a
Price of the
Commodity Purchased
Commodity
A commodity like salt has more utility but
has only a small exchangeable value. In
such cases, consumers surplus will be
more. A commodity like diamond has only
a limited utility but has a great exchange
value. In this case, the consumers surplus
will

0
M
Quantity Demanded
Fig.7.2 Consumers Surplus

be

less.

Thus,

the

concept

of

consumers surplus is used to distinguish

In the figure 7.2, total utility of OM units is equal to ODSM. But given the
price OP, the consumer will actually pay for OM units of the good the sum
equal to OPSM. It is thus, clear that the consumer derives extra satisfaction
(utility) equal to (ODSM minus OPSM) DPS, which has been shaded in the
figure.
CRITICISM:
a) MU of money doesn't remain constant.
b) Utility cannot be measured cardinally.
So Hicks gave his Indifference Curve (IC) approach.

2. Hickss Indifference curve approach

Money is measured in Y axis and commodity A on X axis. Consumer has OY1
money with him. Indifference Curve Io shows he is indifferent between OY1 of money and
any combination of money and commodity A on it. Eg. He is indifferent between OY1 of
money on one hand and OH of commodity A plus OS (=HR) of money i.e. he is prepared
to pay FR (=Y1 S) money for OH of commodity A. He is obtaining OH amount of
commodity A as against FR amount of money depends upon his preference and is
independent of any price in the market.
Y
F

Money

Y1

P
I1

I0

Commodity A

Fig 7.1 Equilibrium in IC approach

Suppose that the price in the market is represented by price line Y1 L money with
the consumer remaining the same. With this price he will be in equilibrium at point P on
higher Indifference Curve I1 and he will actually pay FP (= Y1 T) money for OH of
commodity A. But independent indifference curve of the price in the market he was
prepared to pay FR money for OH of A. Thus he has to pay PR money less than what he
is prepared to pay. Hence PR is surplus which accrues to consumer because of the fact of
this particular market price.
This technique is quantity compensating variation in Hicksian terminology.

Difficulties in Measurement
Due to changes in MU of money and MU of commodity, consumers circumstances,
sensibilities, non-availability of complete list of demand prices, and also in nature of
commodities such as necessaries, commodities used for distinction it is difficult to
measure CS. Despite this, CS is useful in following ways.
b) Importance of Consumers Surplus
1) Distinction between value- in-use and value-in-exchange: Value-in-use of
a commodity signifies the utility or satisfaction it provides to the consumer,
while value-in-exchange means the price paid by the consumer for the
commodity.
2) Helpful to monopolist in price fixation : Monopolist fixes price of a commodity
in such a way that it bears at least a part of consumers surplus. However, he cannot
absorb the whole of the surplus, as there may be opposition from the consumers.

3) Helpful to policy makers: The policy makers can impose tax, if the
consumers surplus for a commodity is very high. Similarly, subsidy can be
granted, if the consumers surplus is low.

4) To workout cost benefit analysis of a new investment / project.

5) To understand the benefits from international trade.

Questions for Review:

1.Fill up the blanks
a) When price of a commodity increases, its quantity demanded --------b) The three kinds of demand are ------, --------- and ---------.
c) When price of a commodity is constant, an increase in income results in ---d) The demand for common salt is ----------------.
e) As the demand for tea increases, it results in increase in demand for sugar.
Therefore, the demand for tea and sugar is called ---------------f) The concept of consumers surplus will be useful to ------------ the price.
g) The consumer is at equilibrium when he purchases six mangoes at the rate
of Rs.2 per unit and the total utility is 20. Then, he derives ----------- worth
of consumers surplus.
2. Give examples to the following:
a) Joint demand
b) Elastic demand
c) demand
d) Substitutes
e) Inelastic demand
f) Derived demand
g) Composite Complementary goods
h) Inferior goods
i) Giffen goods
3.
a)
b)
c)
d)

Differentiate the following:

Price demand and Income demand
Direct demand and Derived demand
Extension of demand and Increase in demand
Substitution effect and income effect

e) Perfectly elastic demand and Perfectly inelastic demand

f) Inferior good and Giffen good
g) Arc elasticity and Point elasticity

4.
a)
b)
c)
d)
e)
f)
g)
h)

Write short notes

Cross demand
Law of demand
Demand schedule
Consumers surplus
Income elasticity of demand
Cross elasticity of demand
Engels law on family expenditure
Elasticity by Total Expenditure Method

5.
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
l)

Answer the following

Write briefly about the price elasticity of demand.
Describe the factors affecting demand.
Explain in detail how the law of demand is derived?
Write in short the exceptional demand curve.
Describe in detail the measurement of elasticity of demand.
Explain the different types of price elasticity of demand.
Explain the factors influencing price elasticity of demand.
What are the uses of elasticity of demand?
Explain the different types of income elasticity of demand.
What are the implications of Engels Law on Family Expenditure?
How the study of family budget will be useful to policy makers?
Briefly write on the importance of consumers surplus.